Readers Question: Why is the money multiplier in the under states smaller then the inverse of the required reserve ratio? Help (note: not on UK A Levels – my British readers may be relieved to know)
- The Money Multiplier refers to the amount that commercial banks can increase the supply of money in an economy. This is calculated by:
- Increase in money Supply / Increase in monetary base that caused it
For example, if the commercial banks gain deposits of £1 million and this leads to a final money supply of £10 million. The Money multiplier is 10.
- The Reserve Ratio is the % of deposits that banks keep in liquid reserves. (Central banks used to set a minimum reserve ratio as a way to control the supply of money)
- If you had a reserve ratio of 5%. You would expect a money multiplier of 1/0.05 = 20
- This is because if you have deposits of £1million and a reserve ratio of 5%. You can effectively lend out £20 million.
- However, it is possible that if you have a reserve ratio of 5%, the money multiplier may be smaller than 20. This could be due to a number of reasons:
- Currency Drain Ratio. This is the % of banknotes that individual consumers keep in cash, rather than depositing in banks. If consumers deposited all their cash in banks, there would be a bigger money multiplier. But, if people keep funds in cash then the banks cannot lend more
- Safety reserve ratio. This is the % of deposits a bank may like to keep above the statutory reserver ratio. i.e. the required reserver ratio may be 5%, but banks may like to keep 5.2%.
- It might not be possible to lend more money out. Just because banks could lend 95% of their deposits doesn’t mean they can, even if they wanted to. In a recession, people may not want to borrow, but they prefer to save. Therefore, the banks end up with a higher reserve ratio than is the profit maximizing point.
Therefore, due to these and other factors, the reserve ratio is often just theoretical. Banks may not lend out as much as is theoretically possible. Therefore, the money multiplier is less than the theoretical prediction.
(disclaimer: It is a while since I studied this topic, I had to look up some textbooks. It is not taught for UK A Levels)